Low cost of capital, ample liquidity and the potential for capital gains tax increases were some of the leading factors that made 2021 a record year for M&A. While 2022 has faced economic headwinds and deal volume is trending notably short of prior-year levels, there is evidence across multiple fronts that suggests M&A markets are still open for business.

Earlier this year, private equity firms were resting on an all-time high $1.8 trillion of dry powder–the cash available to fund managers that hasn’t been allocated to a specific investment. Deployment of this capital will continue to drive deal flow. On top of significant dry powder, private equity firms have access to leverage via debt, resulting in many multiples of this figure available for M&A.

Strategic buyers have been less acquisitive year to date relative to private equity firms but still maintain an appetite for M&A due to the growing need for technological advancements, access to labor in the face of shortages and rising costs, and competitive pressures in the marketplace. Similar to private equity firms, they also have significant capital available, with over $1 trillion of cash on the balance sheets of S&P 500 companies.

Upward momentum in valuations has slowed, but we have yet to see any dramatic decreases. According to data collected by BMO’s U.S. middle market M&A team, the rolling three-year median middle market enterprise value multiple through September 2022 was 11.4x, only slightly trailing 12.0x in 2021 (deals between $25 million and $1 billion). Companies that are well positioned for the current macro environment and have above-average financial characteristics continue to garner strong multiples. While not an exhaustive list, some characteristics of such businesses are those that have strong track records of growth, healthy margins, lower labor dependence and experienced leadership teams.

Labor shortages and supply chain challenges continue to be ubiquitous across the economy. As of November, the Federal Reserve has raised its target rate to a range of 3.75% to 4% this year, with another increase expected before the end of the year as the U.S. economy continues to grapple with record inflation.

The impact of inflation and modeling recession scenarios will be of heightened importance during due diligence. With rising costs of capital and uncertainty lingering in the financial markets, expect buyers to be more selective in their bids as only the strongest investment will clear underwriting approvals. As is typical during the back-end of any calendar year, several deals will be rushed to close before the new year arrives. Between 30% and 40% of any given year’s deal volume typically closes in Q4.

Companies looking to sell would be wise to earnestly consider and define their value proposition. The deeper buyers must dig to discover a company’s value, the lower the likelihood of a deal getting done in today’s environment. Buyers are looking for companies with product and/or service differentiation, diverse end markets and resiliency to a wide variety of market conditions. Sellers that focus on demonstrating these concepts prior to commencing a sale process can quickly find their way to an attractive valuation and simplify the diligence phase of the transaction.

While valuations are holding up for the right companies, liquidity tends to retract as the economy moves toward a recession. For now, the days of record-low cost of capital are behind us, forcing strategic and financial buyers alike to get more creative when they think about capital structure. With this, sellers should be open to accepting noncash considerations as part of the purchase price.

For example, private equity firms often prefer sellers to rollover a portion of their sale proceeds as equity in the new company to incentivize business performance post-close. Sellers could also be asked to take a note as part of the transaction. In cases where less than 100% of the cash is received at close, sellers should be compensated for the risk of deferring proceeds (e.g., interest on a seller note).

Pursuing the right deal as a buyer is more important than ever. New diligence concerns have come out of the woodwork over the past couple of years. Supply chain dynamics and human capital are no longer secondary diligence streams—they’re of paramount importance in navigating toward a successful transaction. A quality of earnings, or QoE, report will also be critical in understanding a company’s sustainable EBITDA, cost structure and pressure points. Finally, buyers should generate a strong investment thesis that will create value post-close. Working with existing management to identify opportunities, which could come in the form of top-line growth or cost synergies, should not be overlooked.

Doing the right deal also means that the expected return on investment meets or exceeds a firm’s cost of capital. Chevron CEO Mike Wirth said the following after bowing out of a bidding war for Anadarko Petroleum in 2019: “Winning in any environment doesn’t mean winning at any cost. Cost and capital discipline always matter, and we will not dilute our returns or erode value for our shareholders for the sake of doing a deal.”

It could be the returns analysis, a red flag that comes up during diligence or the opportunity cost of another target that signals it isn’t the right deal. In these cases, buyers should have the discipline to walk away.

Dan Murphy, Managing Director, BMO Corporate Advisory and Grant Garner, Associate, BMO Corporate Advisory, contributed to this article.